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One of the biggest decisions a small business owner faces is whether to own the business personally or to form a separate, statutory business entity. If you have decided to form a separate entity, there are more important choices to address before bringing your entity to fruition. Five major choices, to be exact.
Sandra Feldman, Publications Attorney at CT Corporation, breaks down the five big decisions small business owners need to make after deciding to incorporate. These include deciding on entity type, formation state, business name, tax status, and Registered Agent.
Greg Corombos: Hi, I'm Greg Corombos. Our guest this week on Expert Insights is Sandra Feldman. She's the Publication's Attorney for CT Corporation. Sandy’s been with us on a couple of occasions to talk about the critical decisions that business owners need to make in deciding to pursue a formal business entity and some of the things you need to know, for example, when you're setting up a Limited Liability Company. So, today we're going to be looking at five major choices that business owners have to make after deciding that they're going to form a statutory business entity. And Sandra, thanks very much for your time today. We appreciate it.
Sandra Feldman: Thank you for having me. As you noted, in an earlier podcast I mentioned that one of the first and most important decisions every business owner has to make is whether to own the business themselves or form a separate statutory business entity—and that's just the first of many important choices facing them. And today, I wanted to delve deeper into the choices that business owners will have to make after deciding to form a statutory business entity and before they filed the documents that will actually create that entity. I call them the five big choices of entity ownership and they are, in order: choice of entity type, choice of formation state, choice of entity name, choice of tax status, and choice of Registered Agent. And for those of you who love acronyms (and I know you're out there) I give you ESNTA, which stands for entity, state, name, tax, and agent.
GC: Excellent. Well, let's get into those five key points that you just mentioned there Sandra, because it's absolutely critical—once you decide that you are not personally going to own the business—to protect yourself for liability reasons how, exactly, you're going to go about setting this up. So you say the first choice is which kind of entity to form and obviously, there are lots of options there, so what goes into that decision?
SF: That's true. And I will point out that there are a lot of statutory business entity types and every business owner should pick the one that best fits their needs, kind of obvious. Now Limited Liability Companies or LLCs are appropriate for almost any kind of business. And they're very popular, especially with small business owners for, among other reasons, they're very flexible on how they allow the owners to split their financial rights. They let the owners participate in management, and they provide favorable pass-through taxation. But, for entrepreneurs who are planning on an IPO in the future, or who are looking for venture capital funding, or to want to provide their management and employees with stock options, a corporation would be a better choice. And professionals like lawyers and accountants and doctors think that really like the Limited Liability Partnership, or LLP. Business owners who are not only looking to make a profit but also serve a charitable or socially beneficial mission, they may prefer a benefit corporation. So you see, there's a lot that goes into that choice of entity decision.
GC: Oh, absolutely. Right. And obviously, there's many different discussions we could have on that. But the next step that you point out, Sandra, is you need to choose the formation state. In other words, the literal state in the U.S. where you're going to officially form this, this entity. Most people would assume that's just the state where your business is located, but not necessarily.
SF: That's right. It can be where the business is located and, in most cases, it probably will be. But I still need to point out that it doesn't have to be—you can choose a formation state even if the entity isn't located there or doing any business there, or even if you couldn't locate that state on a map. Although, if the business is going to be conducted in only one state, it makes sense to choose that state as the formation state because otherwise, you'll have to register the entity in the state where it's doing business and there’ll be initial and annual fees and reporting requirements in two states instead of one.
But a business owner should still put some thought into it because the main significance of the formation state is that it is that state's business entity statute that will govern that entity. So for example, if you choose a corporation as your entity, and Delaware as your formation state, that entity will be governed by and must comply with the Delaware General Corporation Law. If you choose an LLC as an entity, and New York is the state, that entity will be governed by and must comply with the New York Limited Liability Company Law.
No two business entity statutes are exactly the same. So, if there's a provision of the governing statute of the state where the business is located that you don't like, you can avoid it by forming elsewhere. Or, if there's something about another statute you particularly do like, you can form in that state. And in fact, there are many, many corporations and unincorporated entities that choose Delaware as their formation state, even though they aren't located there, because the people who are choosing the formation state really like Delaware's business entity statutes and the courts that interpret them.
GC: We’re speaking with Sandra Feldman. She's a Publications Attorney for CT Corporation and we're talking about the five big choices that business owners need to make after simply deciding to form a statutory business entity. We've talked about which kind of entity to form, which state to have the formation reside in. Next up, Sandra, is I believe choice of name. Is that right?
SF: That's right, Greg, and the business owner’s choice of entity and choice of formation state actually affect the choice of name. So one thing the entity’s name will have to contain words or abbreviations that indicate what type of entity it is. And they'll also be certain words or phrases that cannot be in the name or that can be used only with permission, and that list of words or phrases will be different for each formation state.
Importantly, the name cannot be the same as the name of any other business entity on the records of the formation state’s filing office. So it's a good idea to do a name check to find out if the name you want is available and, if it is, to reserve that name until you file the formation document. Because the last thing a business owner needs is to spend money on signs, marketing, materials, advertising and so on with the name they like and then finding out they can't use it.
GC: Yeah, you can save yourself a lot of money and a lot of headaches by doing some due diligence there. The next step, Sandra, is choice of taxation. Can a business owner really choose how their entity is going to be taxed?
SF: To an extent, yes. I'm talking about how it will be taxed to federal income tax purposes, and there are two choices. The entity can be a separate taxable entity. Meaning, it will pay the taxes on its income on its own tax return at a tax rate, which is now 21%.
Or it can be a pass-through entity, meaning the entity doesn't pay the taxes. Instead, its income passes through to its owners who pay taxes on their share of the income on their personal income tax return at the personal income tax rate.
Unincorporated entities like LLCs and LLPs can choose either separate or pass-through taxation. But it's a little harder for a corporation. In order for a corporation to be a pass-through entity it has to meet several requirements of the tax code, including having no more than 100 shareholders, none of whom can be business entities or non-U.S. citizens. And it can only have one class of stock.
GC: Down to the final choice here. The fifth choice out of the five that we need to make here once we decide to form a statutory business entity, the choice of a Registered Agent. What kind of considerations are involved in that?
SF: First, I should note that regardless of the choice of entity and the choice of formation state, the business owner must choose a Registered Agent. The Registered Agent’s main function is to receive Service of Process, which is the document notifying the entity it's being sued and to forward it to the entity so that it can respond.
The choice of Registered Agent basically comes down to choosing an individual, like an owner or a manager or employee, or a service company that can provide a professional Registered Agent. And, full disclosure, I work for a service company that provides professional Registered Agent services so it's no surprise that I think that's the way to go. I will point out that a professional registered agent will cost more. But you'll have the assurance of knowing that there will always be someone there at the statutory address when the documents are served and the person receiving them knows exactly what those documents are and what to do with them.
And I think with that, Greg, we've covered five very important choices that many small business owners will be facing.
GC: Absolutely right. So, peace of mind is important as well on that last one. Sandra, thanks very much for your time today as always, we appreciate it.
SF: Oh, thank you, Greg. I enjoyed it.
GC: Sandra Feldman is Publications Attorney for CT Corporation. I'm Greg Corombos.
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